This blog by Siobhan Pender, sustainability Intern at IEN explores the misconceptions around the volatility of ESG funds in retirement plans and the step process to add ESG funds to your retirement plan line-up.

Misconceptions about the volatility of ESG funds in retirement plans have resulted in a wariness surrounding the potential for including them in portfolios. An ESG fund is one that integrates environmental, social, and governance factors in its portfolio analysis in order to obtain superior returns without undue risk. However, these apprehensions have proven to be unfounded, as Morgan Stanley’s Chief Sustainability Officer and CEO of the Institute for Sustainable Investing Audrey Choi has stated, “[s]sustainable investments have continued to perform well throughout 2020, reinforcing the value of sustainable investing and further dispelling the myth that investors who include sustainability considerations in their portfolios face a financial trade-off.”

Some investors have worried that ESG funds will not provide the same returns as other traditional peer funds, but as evidence has demonstrated, sustainable funds result in the same -- if not greater -- returns, as well as providing more downside risk protection in a portfolio. A 2019 Morgan Stanley report found (1) there is no financial tradeoff in the returns of sustainable funds and traditional funds, and (2) sustainable funds may offer lower market risk, experiencing a 20% smaller downside deviation than traditional funds. As legislation continues to evolve, with regulations pushing companies to disclose more information on sustainability, this will result in more data for investors to utilize to measure ESG risks and opportunities.

The Intentional Endowments Network (IEN) created a new Sustainable Retirements Guide to address these misconceptions and hopefully clear up some of the questions plan sponsors, HR Officers, and employees may have about sustainable retirement portfolios, as well as providing information on how to start including them (ESG Funds) as options for retirement plans at their institutions.

THREE Highlights Regarding the Performance of ESG Funds:

There has been a common misconception held by plan sponsors and investors that selecting ESG Funds as part of retirement plans risked sacrificing investment performance when compared to other traditional funds. This section highlights the main facts regarding ESG Fund performance, and they are expanded upon in the Guide found here.

1. The majority of studies done to understand the relationship between ESG criteria and corporate financial performance indicate that ESG criteria improved market performance, as found in a review by Sustainable Finance and Investment research. This type of ESG investing is becoming more widely accepted among investors and asset managers, who see the potential for sustainable portfolios to yield attractive financial returns alongside positive environmental or social impact. (Performance Module of the Guide)
2. ​​ESG funds outperform peers since ESG funds take into account all the data that “underlies the materiality of a company that’s not financial,” and since the ESG framework provides investors with more data and information to work with, taking into account ESG risks and opportunities enable investors to outperform other peer funds.
3. Sustainable funds outperformed traditional peer funds and reduced investment risk during coronavirus in 2020, with sustainable equity funds outperforming their traditional peer funds by a median total return of 4.3 percentage points during the year. As ESG-related strategies are increasingly outperforming the market, the ESG Funds are less volatile than originally thought. In 2020, sustainable funds demonstrated that investing with an emphasis on how a company manages material ESG risks and how it manages key stakeholders can produce better returns in an uncertain economic setting.

In addition to addressing the misconception around ESG, the Sustainable Retirements Guide also features a five-step process for Plan Sponsors to add ESG funds to your retirement plan line-up, given that employees want to invest in retirement options that align with their values and beliefs, as found in a 2019 study conducted by Natixis.

A "How-to Guide": Five-Step Process to Add ESG Funds to Your Retirement Plan Line-Up

Given the extensive amount of research and evidence demonstrating strong ESG Funds performance, here are a few steps on how to introduce them into retirement plans to yield financial returns and impact.

1. Gain a Basic Understanding: First, it is important to gain an understanding of the benefits of ESG funds included in retirement plans, and to increase your knowledge of ESG investing by asking questions like, “What is the current regulatory environment regarding ESG funds? Should I be concerned about the performance and fees of ESG Funds?”
2. Examine the Interest of Your Employees: It is important to determine first, if employees would be interested in having ESG funds on the investment platform, and second if adding to and/or replacing current funds with ESG funds is the best decision.
3. Implementation (Selecting Funds for Consideration): Having the right amount of funds to consider is important for employees, and so a set of carefully selected funds will make the process easier. It is also a good idea to examine and determine the right mix of ESG funds to add, taking into consideration fiduciary duty and participants’ desires, among other things. 
4. Communicate and Educate Employees: The process of communicating plan changes to employees prior to the change should be made when offering ESG funds, since when employees have a better understanding of their investment options, it allows them to make better decisions.
5. Monitor the Funds: ESG funds should be subject to the same performance review and benchmarking as other funds, and you may also want to review the ESG funds for adherence to their environmental, social, and governance objectives.

Including ESG funds in retirement portfolios is only going to grow in the coming years, especially as larger interests become involved. Most significantly is that the US’s largest retirement plan -- the US$760 billion Federal Thrift Savings Plan -- will begin to offer the option of investing in ESG mutual funds next summer. With President Joe Biden’s May executive order on climate-related financial risk, asking the secretary of labor to assess “how the Federal Retirement Thrift Investment Board has taken environmental, social, and governance factors, including climate-related financial risk, into account.” With evident high performance, large returns, and positive social and environmental benefits, plan sponsors should feel confident in evaluating ESG options for inclusion in their fund offerings.

Going forward, IEN Retirement Initiative is working on releasing two new modules, one on fiduciary duty concerns and the other on advocacy, with outlined steps on how to advocate for ESG integration in retirement plans. In the meantime, you are welcome to read the full retirement guide here.

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As an undergraduate, including sustainable funds in a retirement investment portfolio, is important not only because I believe it reflects the values and interests of an institution and its faculty and students, but also because it helps in ensuring that myself and my other fellow students have a liveable planet to inhabit in the future. Sustainable funds are important to include in a portfolio because they provide stable returns, of course, but also because they provide for the future - investing in a long-term strategy to further sustainability goals and projects.

I’m so grateful for this internship experience with IEN that I was able to participate in this summer, as a result of the funding provided by the Massachusetts Clean Energy Center. I am incredibly thankful for the help, advice, and wisdom provided by the IEN Team as they truly welcomed me into their team this summer. I also want to thank the Retirements Expert Panel for including me in their calls and for providing me with an active role in furthering the goals of the group’s projects. As I move forward in my academic career in Environmental Studies and Economics in my final year as an undergraduate at Boston College, my newfound knowledge regarding sustainable investing and finance will continue to inform my future endeavors.

Keep in touch with Siobhan Pender here